Corbett investigated whether U.S. domestic equity mutual fund managers have been able to capitalize on broad style movements through style-rotation strategies, or whether this behavior eroded value. His study covered almost 6,000 funds for the period from January 2010 to August 2015. Style rotation was measured through both a returns-based (using factor regressions) and a holdings-based (using Morningstar style boxes) approach. The following is a summary of his findings:
- On average, fund managers most prominently rotate portfolio exposures across value-growth and size style dimensions, followed by momentum and then market exposure.
- The sample’s average style-timing ability is negative yet insignificant for all style dimensions except value-growth, which is insignificantly positive. This implies that the average fund has no style-timing ability.
- On average, funds that most frequently rotate across stock-size exposures are significantly worse at timing size returns.
- On average, funds that most vigorously rotate across momentum stocks perform significantly worse, at the 5% level of statistical significance, than the most style-consistent funds.
- An inability to time the market, along with the associated costs of rotating market exposures, is shown to be detrimental to the performance of high market-rotating funds.
- About 80% to 90% of U.S. equity mutual funds had no style-timing ability over the sample period.
- Fund managers that engage in style rotation perform worse on a risk-adjusted basis than managers who maintain consistent style exposures.
- The average fund has insignificantly negative stock-selection ability, implying that funds on average are unable to profit from successfully selecting undervalued stocks.
- More than a quarter of all funds exhibited negative abnormal returns. Only about 2% of funds exhibited significantly positive abnormal returns.
The Bottom Line
In a recent study, Morningstar found that over the three years ending July 2014, TAA funds gained an annual average of 7.8%, or 3.8% per year behind their benchmarks. In addition, Corbett’s finding that only about 2% of funds exhibited statistically significant alphas is consistent with what professors Eugene Fama and Kenneth French found in their paper, Luck Versus Skill in the Cross-Section of Mutual Fund Returns, which was published in the October 2010 edition of the Journal of Finance. They found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill.
As my co-author, Andrew Berkin, and I explain in our book, “The Incredible Shrinking Alpha,” there are four trends that explain why this is the case: the supply of victims that can be exploited has fallen dramatically; sources of potential alpha have been disappearing as academic research is published that converts alpha into beta (a common factor); the supply of dollars chasing alpha has grown dramatically; and the competition has become increasingly more skillful. These trends have conspired to reduce the odds of outperforming by a relative 90%! And remember, all the above figures are based on pre-tax returns, and for taxable investors the largest expense of active management is often taxes.
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